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Head And Shoulders Pattern
The Smart Profits Report: Issue #291
Tuesday, March 14, 2006
Head and Shoulders Pattern: A Proven Sell Signal Called Breaking the “Neckline”By Jim Stanton
Advisory Panelist, Mt. Vernon Research
Study stock chart patterns for a long time and you’ll come to one inescapable conclusion: They are a picture of fear and greed.
Once I became a seasoned chart analyst, I noticed similar patterns in a number of different stocks. They were not only present in the intraday charts, but in the daily and weekly charts, too.
Since then, I have developed a proprietary trading model based on advanced pattern recognition. But the one pattern I go back to time and again has been around for many years. It’s the Head and Shoulders pattern. Here’s how it works…
The Unmistakable Time to Get Out
Below is a daily chart of American International Group (NYSE: AIG), which is setting up a potential “head and shoulders” sell signal. This pattern consists of three successive peaks with the middle (the head) being the highest and the two on either side of the head (the shoulders) at slightly lower levels. When connected, the reaction lows at points #1 and #2 form support at what is referred to as the “neckline” (see the red line in the chart).
A head and shoulders “topping pattern” usually appears after an uptrend line has been broken and a subsequent low is tested. That forms the neckline. In AIG’s case, the uptrend line was broken on January 20. The stock then tested its previous low, at point #1, in early February. The test of the January lows was successful and the stock appears to be forming the right shoulder of the pattern.
While symmetry is preferred, it is not an absolute requirement. At times, the right shoulder will be slightly above or below the peak of the left shoulder, as it is in this case. Occasionally, the neckline has a slight up or down slope. A down-sloping neckline indicates a more bearish pattern than a horizontal or up sloping line.
As the head and shoulders pattern unfolds, volume often plays an important role. Ideally, volume during the advance of the left shoulder should be higher than during the advance of the head. The drop in volume, along with new highs that form the head, serve as the first warning sign. The second warning sign occurs when volume increases on the decline from the peak of the head. Final confirmation to sell comes when volume increases during the decline of the right shoulder.
The Head & Shoulders Top
At this point in time, we don’t know if AIG is forming a head and shoulders top or just consolidating its recent gains. The head and shoulders top is not complete and the uptrend is not reversed until the stock closes below the neckline. Ideally, this should occur in a convincing manner with an increase in volume. Once the support at $64.60 is broken, it triggers the sell signal and the $64.60 level now becomes resistance. At times, the stock will bounce back up to the resistance level, offering a second chance to sell the stock.
Once the neckline support is broken, the projected price decline is found by measuring the distance from the top of the head to the neckline. This distance is then subtracted from the neckline to reach a price target, which in AIG’s case is $58.30. The stock could drop to either side of $58.30, so traders should watch that general area for signs of a reversal.
Stay tuned for more pattern tips in the coming weeks. And until then, keep an eye out for “head and shoulders” patterns forming in any stocks you own, and be sure to track that right shoulder to see if it’s time to cut your losses.
Good Trading,
Jim
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Today’s Smart Profits Cribsheet
- Is now a good time to buy an option? Or should you opt for the stock instead? Check out Smart Profits #145, Market Volume & Liquidity: When to Buy the Stock And NOT the Option, for guidance on this sometimes-difficult decision.
- It’s not enough to get to know chart patterns if you’re planning on using them to trade for profits. After all, knowing when to get into a trade is only half the battle. See Smart Profits #286, Understanding Option Trading: Cut Your Losses… And Watch Your Gains Run, before you enter your next trade.
- Unsure of option terminology such as “volume” or “trend” used above? Check out the Smart Profits Glossary, chock full of over 150 different option terms!
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